Tax Law and Treaty Shopping.

To avoid double taxation and to promote economic integration, countries bring to force double tax treaties/agreements (DTAs). These treaties are entered into by the two states (contracting states), spelling out which jurisdiction has taxing rights over certain transactions. Kenya, for instance, has in force 14 DTAs, 7 signed but not yet in force DTAs, 7 concluded but not signed DTAs, 5 DTAs under negotiation, and 15 DTAs under consideration.

So how do multinational corporates use this practice to their advantage? Let’s get to it.

Consider two contracting states in a DTA, Country A and Country B. Country A has in addition 19 other DTAs while country B has 14 other DTAs. Of A’s 20 DTAs and B’s 15 DTAs, only 10 countries are common, the other 15, are completely different. This is the reality of Double Tax Agreements. Now, extrapolate this relationship over the entire globes nations. You realize that a multinational, in its tax planning views the world as an intricate network of local tax laws and tax treaties.

What does the multinational corporate do? They will analyze the network of Double Tax Treaties and the internal tax laws of the countries involved in depth and identify the treaty routes of least taxation. The multinational then creatively channels funds through such a path leading to favorable effective tax rates or sometimes, 0% overall tax rate.

**When designing DTAs, contracting states must take care that the treaty does not result in double non-taxation, where income ends up not being taxed in either state.

One of the most aggressive modern tax strategies involving tax law & treaty shopping is the now defunct Double Irish Dutch Sandwich, prominently employed by technology companies. When orchestrated, it would lead to practically little to zero taxes paid by a multinational in 4 or more jurisdictions.

Planning: The main company is setup in the United States. It then setup two associated companies in Ireland, one in Netherlands and one in a Tax Haven such as Bermuda. The main company has critically analyzed tax laws of each country and any DTAs in force amongst them. The multinational has identified and intends to take advantage of the following network of factors:

Factor 1: A company is resident in the United States if it is incorporated in the United States, otherwise, the company is outside the US’ primary taxing rights.

Factor 2: Ireland bases residency on effective management. So even if a company is incorporated in Ireland but is management from a different country, it is not considered an Irish resident company, therefore it is outside Ireland’s primary taxing rights.

Factor 3: There are Withholding Taxes should and Irish company pay another Irish company, however, Netherlands has an existing DTA with Ireland and has very limited Withholding Taxes itself.

Factor 4: Bermuda has 0% corporate tax rate.

Execution: The actual development and use of Intellectual Property is with the main company in the United States, however, the rights, patents and licenses for these are then transferred to the first Irish Company (Irish One). Irish One is registered in Ireland therefore it is outside USA’s tax jurisdiction (Factor 1), it is however managed from Bermuda therefore it is outside Irish tax jurisdiction (Factor 2). Irish one sublicenses ‘its Intellectual Property’ to the second Irish company (Irish Two), which is managed from Ireland, so it is within Irish tax jurisdiction. Irish Two does business with the Intellectual property all around the globe, making mega-revenues. If these revenues are retained within Irish Two, they will translate to huge profits, which will be taxed by the Irish Government. So, Irish Two then transfers substantial amounts of these revenue to the Dutch company, leaving little profits for the Irish Government to tax and comfort themselves. The Dutch company transfers the revenues to Irish One at zero (0) withholding tax (Factor 4), leaving no profits in Netherlands. Now, all bulk of revenue is with Irish One, but, the Irish Government will not tax them since Irish One is managed from Bermuda, this is outside Irish tax jurisdiction (Factor Two). Irish One can choose to transfer profits to Bermuda if so wished since Bermuda Corporate Tax is … 0%.

As far as revenue from the multinational’s Intellectual Property goes, they have paid 0/- tax in the US, little to no tax in Ireland, 0/- tax in Bermuda and 0/- tax in Netherlands.

In practice, Multinationals don’t employ a singular international tax strategy but often an aggregation of multiple interwoven strategies.